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The Actuary The magazine of the Institute & Faculty of Actuaries

Is immigration the answer?

The UK pensions industry is undoubtedly in crisis. In the first report of his Pensions Commission in October 2004, Adair Turner outlined the complex difficulties that are faced by the UK. Turner identified two ways to keep pension schemes viable: paying higher contributions and working longer. One way that he did not consider, however, was by increasing the working population by immigration.

The problem
There are not enough workers to support pensioners because we are living longer and birth rates have fallen. In 1990 there was one pensioner in the UK for every four workers. By 2030 there is projected to be nearly two for every five. Such a society faces tough decisions if it is going to have a viable pay-as-you-go (PAYG) state pension policy. Credible pension policies must show fairness to each generation the ratio of a society’s pension bill to its wage bill cannot increase forever.
My colleagues and I recently developed a mathematical model to make future predictions about the UK basic state pension, given five different scenarios:
– Scenario 1 No change: no productivity growth and no changes to activity rates, pensions, or contribution rates from 2002.
– Scenario 2 Wages change: wages increase at the historical rate of 2.1% real; no change in other variables.
– Scenario 3 Pensions reduce: a cut of 1% pa real in pensions; no changes in other variables.
– Scenario 4 Wages and pensions increase: wages increase at 2.5% pa real and pensions at 1.5% pa real; no changes in other variables.
– Scenario 5 Many changes: wages increase at 2.1% real and pensions at 1.5% pa real, state pension age is transitioned to 70, there is a quarter-of-one% rise in productivity for over 50s; no changes in other variables.

Scenario 1: No change
There would be a contributor shortfall, which would build into a huge deficit if it is not corrected. In order to keep the system in balance, frequent increases in the state pension age would be required. The government’s present policy of gradually aligning the state pension age of women to that of men between 2010 and 2020 (see the dotted line labelled ‘transition 1’) would not be sufficient to solve the problem.
Up to 10m migrant workers might need to enter the UK between now and 2025 in order to ensure that pensioners can continue to receive a basic state pension of £80 per week.

Scenario 2: Real wages increase at 2.1%pa
A substantial surplus would build up over the projection period. With present government policies, shown in the dotted line (‘transition 1’), the rate of increase in the annual surplus would start to diminish after 2020 and the surplus itself would disappear sometime in the 2030s.
The state pension would be able to increase in real terms at 1.5% pa up until 2020. After this, the contribution shortfall would continue to rise again and state pension age would have to increase beyond 65.

Scenario 3: Real pension reduction of 1%pa
A 1% pa real cut in pensions would keep the system in balance until 2014 assuming an average state pension age of 62.5. The planned increase in the state pension age for women to 65 (‘transition 1’) has the effect of keeping the state scheme viable until 2023. Indeed, there is a contributor surplus between 2010 and 2023. In theory this could be given back to pensioners in the form of higher pensions, but the annual rate of increase in pensions would have to be below the rate of increase in wages for the policy to work. There would need to be further increases in the state pension age after 2023 to maintain the viability of the system without additional immigration.
Note that in a PAYG system, a real pension reduction of 1% pa has exactly the same effect as a real wage increase of 1% pa or a contribution rate increase of 1% pa.

Scenario 4: Real wages increase of 2.1% pa and real pensions increase by 1.5% pa
Under the government’s current retirement age policy, the system could provide a 1.5% pa increase in pensions until 2020 after which deficits would accumulate rapidly. The small hump around 2009 would be caused by the retirement of baby-boomers.

Scenario 5: Real wages increase at 2.1% pa, real pensions increase by 1.5% pa, SPA 70 after 2020, 0.025% pa rise in productivity
This scenario could keep the UK state pension system viable until 2024 without any immigration pressures. Without the increase in the state pension age to 70, the immigration pressures would begin after 2018.
Expecting everybody to work longer is unrealistic as activity rates among the over-50s have hardly changed in 25 years, and so to make any difference there would have to be a change in working habits.

Decision time
The UK is facing some tough decisions in terms of state pension provision: we can increase our workforce via immigration, we can work longer, or we can increase contribution payments but even if we do this it only keeps the current state pension system stable until 2030. In each of the scenarios modelled, the pension contribution shortfalls will become increasingly difficult to manage after 2020.